5 C s of Credit o Character Specific purpose of the loan and the seriousness of the intent to pay o Capacity Legal authority to sign a binding contract and sufficiency of the borrower s cash flow to service the loan o Collateral adequate assets to support the loan in the case of default Measured by May include personal security of borrower o Conditions assessing the impact of changing economic conditions on the borrower s value ratio ability to repay o Capital assessment of the adequacy of the borrower s capital to prevent solvency Regulatory Capital o Also known as Capital Requirement o The standardized requirements in place for banks which determines how much liquidity is to be held for certain assets o Regulated by BIS and FED and is put in place to ensure banks are not participating in decisions that increase default risk and will be able to honor withdrawals from customers and sustain operating losses o Typically the of regulatory capital is based on the risk of that bank or company Z score Analysis Altman c o Also known as discriminant score o Uses historical data on actual loan bond performance default vs non default o Z score isn t intended to predict if a firm will go bankrupt It measures its resemblance correlation to other firms that have gone bankrupt o It IS NOT just for publically and privately held firms o It can t be used to estimate the probability of default PD o Benefits Speed consistent accuracy ability to separate customers into different risk classes reduce bad debt loss reduce personnel costs used for decision support compliance and is easy to re evaluate loans The zone of ignorance or grey area The area between rejecting and accepting This can lead to misclassification In order to get a definitive answer the bank will need more information about the borrower Type 1 Error Failure to reject an applicant who will default on a loan more costly Type 2 Error Rejecting an applicant who will not default on a loan Credit Analysis o Use to distinguish good from bad credit risks Determine the Probability of Default Determine Loss of Given Default o Allows banks to Screen out risky loans Price loans in accordance to their risk Continue to monitor credit quality over the life of the loan o Usually involves some form of Credit Scoring Construction Spreading and Analysis of Pro Forma Financial Statements o Used to establish cut offs between acceptable and unacceptable credit risks Quantitative Credit Scoring decisions o Scores reflect o Statistical Analysis of Credit Scores to define cut off values for use in future credit Probability of Borrower Default Quantitative measurements that are correlated with default Statistically based decision rules o Can also be used to sort borrowers into different risk classes o Utilizes historical information from loan applicants and credit bureaus to determine which borrower characteristics are most useful in predicting whether a loan is repaid or not Expert Systems o Also known as subjective analysis Relied heavily on banker s subjective analysis experience o Relied on the construction and subjective analysis of financial ratios and pro forma financial statements along with local knowledge of the borrower o Both Expert systems and Qualitative Credit scoring have no sound theoretical and statistical basis Based on experience and trial and error Banks rely on Expert Systems and Qualitative Credit Scoring heavily for LARGE SINGLE transactions Loan Rates and Loan Pricing o Loan Pricing Interest Revenue Fee Income This value should be sufficient to cover All cash expenses Expected Losses Provide retained earnings so there is a capital cushion to absorb some portion of unexpected losses Provide return for investors o Loan Rates Typically lenders price loans by adding a risk premium credit spread to base lending rates Ie adding a risk premium mark up to a LIBOR or PRIME rate Doing this also establishes a floor for lending rates o Refers to the uncertainty of forecasted future Cash Flows variance of portfolio stock returns statistical analysis to determine the probability of a projects success or failure o Risk is the likelihood that the outcomes will deviate from expectations unexpected variance o Risk is Uncertainty that is quantifiable Using statistical practices banks are able to determine potential risk for default and the amount of expected losses Risk Analysis Risk Ratings o Most banks have a risk rating system that includes measures of Probability of Default PD risk rating Loss Given Default LGD 1 RCVR o This allows banks to determine the loan s expected loss rate and expected losses o Banks are required to have a minimum of 9 risk classes Logistical Regression o It is similar to Z score but it can be used to directly estimate the borrower s PD o If the logistic regression procedure chooses perfect weights then PD will 1 for default probability of default and PD will 0 for non default Then you could apply the model to new loans and use it to forecast the loans PD KMV Moody s EDF Model Expected Default Frequency Method o Uses an option pricing approach Equity holders own a call option on the underlying asset value of the firm The call option s strike price is equal to the BV of the firm s liabilities Their Call option has value as long as the firm s asset value BV of the firm s liabilities Assures the creditor will be paid and the firm won t default IF the equity investors want to pay o Derives an estimate of PD for each borrower based on Capital structure Volatility of asset returns Current asset value o Default risk is the probability that estimated asset value will fall below a pre specified default point o 3 steps zone 1 estimate current market values and volatility of the firm s assets 2 determine how far the firm is from default Distance to Default or DD 3 Scale the DD to a PD o EDF essentially finds the probability of a firm that they will default within a specific time Term Structure and Risk Neutrality Credit Analysis o One market based method of evaluating credit risk exposure and default risk probabilities is to analyze the risk premiums inherent in the current structure of yields on similar corporate debt or loans to similar risk rated borrowers 1 determine the current risk class of the borrower 2 Map risk class to rating agency 3 Different probabilities of default will be reflected in the degree to which the bond yield for a bond with that rating differs from rate on a T bond risk free bond of the same maturity o Under